Bad News + Silver Lining = Marketing Intangibles Case

Our top story this week brings good news for multinationals in India! Well it’s bad news with a big fat silver lining. 22 MNCs in India have been fighting a transfer pricing tax battle for 4 years. Round 1 of the battle went in favor of the tax department. Round 2 was won by the tax payers. And in Round 3, we have a divided verdict. The Delhi HC decision on marketing intangibles is out and the MNCs have won some and lost some. Payaswini upadhyay gives you a recap of the battle so far, important principles laid down by the Delhi HC and their implications

This case on marketing tangibles began in 2012. The Tax Department claimed that Indian MNC subsidiaries such as LG, Glaxo Smithkline, Maruti Suzuki, Sony, Pepsi Foods, Cannon, Xerox and a dozen others were creating marketing intangibles. That is - the money spent by these Indian companies on advertising and marketing…also promotes the parent brand. And so, the Indian subsidiaries should be adequately compensated by the parent for this service.

In Round 1, the Special Bench of the Delhi ITAT agreed with revenue and said that the foreign parent needs to compensate the Indian subsidiary for the excess advertising and marketing done to build the foreign brand in India.

To determine excess spends - The Special Bench approved of a bright line test used by the tax department to calculate the non-routine expenditure made by the Indian subsidiaries to maintain the foreign brand.

Manisha Pande Leader- Global Transfer Pricing, GE Oil & Gas“The Bright line Test was getting applied in order to see if the comparable had more expenses in respect of advertising, marketing and promotion than the tested party whose profits you are computing, then the excess is something which is non-routine and therefore it should be compensated by the parent. That was Revenue’s contention and most of the taxpayers were getting aggrieved because of that.”

Rahul MitraConsultant- Transfer Pricing“This was the most important point that how the Bright Line was inappropriately applied for all taxpayers in general that no matter who you are and no matter what form of remuneration you are receiving, you have to mandatorily get a reimbursement of the excess AMP.”

Mohan ParasaranSenior Advocate, SCFormer Solicitor General of India“The Special Bench actually laid down various tests – some guiding factors which will be relevant in actually arriving at the arm’s length price and there were various criteria which were helping the taxing authorities to examine various transactions and that was actually followed as a rule book or a thumb rule by the taxing authorities.”

In Round 2, the rule book didn’t quite help the tax department. BMW India – a distributor entity owned by BMW global - decided to fight a separate battle. It argued that its parent did not need to compensate it for advertising and marketing expenses as thate compensation was already factored into its Importation Agreement with the parent. And since it imported the goods at a lower cost, its gross profit and net profit margins were higher than that of its comparables. The Delhi ITAT bought BMW’s argument that it was getting a reasonable gross margin commensurate to its function of brand building in India.

Rahul MitraConsultant- Transfer Pricing“It could be substantiated that the comparables which were chosen in the case of BMW – so BMW’s intensity of functions were more than the comparables- however its gross margins were commensurately more than the comparables and that’s how the tribunal said there was no reason or occasion to get an additional reimbursement for the expenses.”

Manisha Pande Leader- Global Transfer Pricing, GE Oil & Gas“The BMW case was definitely a breather and was a welcome step. The Delhi Tribunal’s appreciation of the functions, assets, risk of BMW and making that distinction in the case of BMW was definitely a breather. Having said that the cases that were there before the Special Bench- all the cases with respect to distribution and the AMP spend with respect to those distributors- that was something that still needed to be clarified.”

To seek this clarity, the Special Bench victims knocked at the doors of the Delhi High Court. They lost but experts say the companies should be delighted with the outcome.

The High Court rejected the taxpayers’ argument that advertising, marketing and promotional expenses are not international transactions.

Manisha Pande Leader- Global Transfer Pricing, GE Oil & Gas“The High Court wanted to make sure that it opines on the principles of transfer pricing and the moot question in the room – whether or not the AMP expenses can be computed with a Bright Line Test and what to do in case of distributors. Instead of getting caught up on whether or not this is an international transaction, the Court said at 2-3 places that look, there is a parent company and there is a subsidiary and there is suitable nexus with respect to these transactions and we believe its very much within the gamut of international transaction in order to proceed further with its transfer pricing analysis.”

That loss has been accompanied by other victories in the same decision. The first important principle in favor of the companies is the High Court’s conclusion on economic ownership of the brand. The tax department has been taking a stance that as a licensee of a brand, if the Indian company is incurring significant amount of expenses on AMP, it should be reimbursed in the same year. Because if the license was impaired at a future date, the Indian company would not be able to earn profits by exploiting the brand and the government will lose out on the tax. That argument had found favour with the Special Bench but was shot down by the Delhi High Court.

Rahul MitraConsultant- Transfer Pricing“The Delhi High Court said let’s cross the bridge when it comes. So let’s not pre-empt that there can ever be an impairment of license and for that, I want to get a share of tax now. If at all there is a termination of the license agreement, then one would need to see in that particular year as to whether the subsidiary needs to be compensated for the impairment of the license based upon several parameters- it’s not that each and every license impairment would entail a compensation. But whether the subsidiary needs to be compensated at all for the impairment would be an exercise in the year in which the license is terminated but not now.”

Manisha Pande Leader- Global Transfer Pricing, GE Oil & Gas“I think this is aligned with the concept of exit charges which many European jurisdictions also have. I think it makes a lot of sense with respect to your day to day transactions and what is more in the long term horizon of a development of marketing intangible.”

There is a second key principle that has gone in favor of the companies – the Delhi HC has concluded that the tax department needs to take a bundled approach towards a transaction. That is - if on applying a transaction net margin method – a company’s margins were in line with the comparables, then individual line items adding up to the margin should not be scrutinized. The tax department had argued in favor of individual comparison – and lost.

Manisha Pande Leader- Global Transfer Pricing, GE Oil & Gas“It’s really nuanced. I think the High Court ruling distinguishes different kinds of distributors- a limited risk distributor, a distributor who is taking some risk vs a fully entrepreneurial risk taking distributor. So it first says that you’ve got to appreciate the function, asset, risk which is the building blocks of transfer pricing. First set that correctly and then choose the method. And if the method chosen is TNMM, then after you’ve done the comparative analysis and looked at the profits of the comparables and if they are found in line, then you need not go back and look at individual line items and try to pull out the AMP expense and ask for further reimbursement of the same. So that is not needed because adequate remuneration has been reported in the subsidiary’s profitability.”

Rahul MitraConsultant- Transfer Pricing“The Delhi High Court has also made a point that overall TNMM cannot be applied for license manufacturers. So this brings in a very important point that the license manufacturers – when they defend their cases on marketing intangibles or even otherwise- they would need to certainly consider that those days of routine, mundane way of working transfer pricing by having plain vanilla TNMM are over. So you have to take transaction-by-transaction approach. Typically for transactions like import of raw materials on a cost plus from the other side, then test the other side. If you have a royalty payment and if you’re able to identify proper third party comparable license agreements, then go for a CUP analysis or do a residual profit split analysis to test out your royalty but not an overall TNMM.”

The third important principle laid down by the Delhi HC poses a serious issue for the tax department. The High Court rejected Revenue’s use of a bright line test to determine excess AMP spend - saying the law doesn’t provide for it. Experts say the tax department has been applying the test mechanically without doing a functions, assets and risk analysis of the company in question. So if the tax department cannot use a bright line test, what options does it have?

Rahul MitraConsultant- Transfer Pricing“In the very remote case, where you can say the distributor’s intensity is so very high as compared to the comparables that you cannot even call them comparables, then you go for a profit split but reimbursement of expenses without looking at any other aspects of the profitability or the financials of the distributor was, is and never be the test or recourse which the Revenue can apply.”

Mohan ParasaranSenior Advocate, SCFormer Solicitor General of India“It’s not so difficult to find out whether or not a particular transaction was at arm’s length. In this developed world, you can’t find out comparable prices. Even though intangibles is a complex issue but still, it’s not difficult for human minds to find out comparables.”

Not sure if the Revenue department will concur with that view! For now, the Delhi HC has laid down the framework for the tax department and companies on the issue of marketing intangibles and sent the cases back to the Tribunal for fresh consideration. Experts say if the Tribunal applies the principles appropriately which it ought to, it will not only bring huge relief for the companies involved but also build Brand India in the process!